A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
Think of Big Tech and companies like Alphabet, Amazon, Apple, and Facebook come to mind. The firms dominate our digital lives, living on our cellphones and influencing how we interact with people, buy things, get to places, access information, and consume entertainment. Their market impact has also been huge: These four stocks have returned 33.7% annually over the past five years, on average, versus the S&P 500’s 14.5%.
Yet while many investors want Big Tech in a basket, David Blitzer wants to cut the group down to a more manageable size. “Based on what these companies do and who they compete with, it makes sense to categorize them differently,” says Blitzer, chairman of the index committee at S&P Dow Jones Indices. “The world ain’t what it used to be.”
Sector investing won’t be the same, either, after the unprecedented overhaul by S&P and MSCI of their Global Industry Classification System, or GICS, a widely used taxonomy that carves up the stock market into sectors, industry groups, industries, and subindustries. The biggest change: A new sector, communication services, is rising from the ashes of the telecommunication-services sector, which will go extinct. The communication sector will cherry-pick stocks from the tech, consumer-discretionary, and telecom bins. And it will be a biggie, the fourth-largest (tied with consumer discretionary) out of 11, behind information technology, health care, and financials. S&P plans to reconstitute its indexes after the market closes on Sept. 28. MSCI’s changes will go into effect on Dec. 3.
For investors in broad index funds, this may seem like much ado about nothing. But a great migration of hundreds of stocks has broad market implications. Some sectors will become more heavily concentrated in a few big names—notably, Apple (ticker: AAPL) in technology, Amazon.com (AMZN) in consumer discretionary, and Facebook (FB) and Alphabet (GOOGL) in communication services. “This will be a meaningful change, and not just because of the migration of stocks. It’s also what happens afterward, and how market cap will be distributed,” says Daniel Prince, head of iShares product consulting at BlackRock.
The changes will have a ripple effect throughout virtually all professional money management, and could mean big changes for investors’ portfolios. Strategists and advisors constantly make sector recommendations, advising clients to rotate through sectors as industry dynamics change. Many quantitative hedge fund managers use sector exchange-traded funds to hedge stock positions. Active managers use sectors as guidelines or benchmarks in their portfolios. Reports breaking down a fund’s performance show whether a manager’s skill at picking stocks is driving the returns, or whether it’s a result of sector weightings. Many funds also aim to outperform by rotating between sectors, going “overweight” or “underweight” at different times.
For individual investors, sectors can be a good way to make tactical shifts, too. Industrials, energy, materials, consumer discretionary, and technology tend to outperform when the economy is winding up. Consumer staples, health care, telecom, and utilities fare best in a downturn. Sectors are also home to bubbles: tech in the late 1990s and financials in the mid-2000s. Avoiding overheated sectors can help you sidestep market excesses.
Of course, sector funds that follow the GICS framework aren’t the only way to go. Investors can assemble their own customized baskets of stocks at minimal cost; trading commissions are down to zero at discount brokerages such as Merrill Edge. Traditional sector ETFs offered by BlackRock, Fidelity, State Street, and Vanguard account for more than $260 billion in assets. That leaves another almost $210 billion in sector ETFs that slice the market in all kinds of other ways.
Sector investing is rapidly evolving, as ETF sponsors apply new techniques to carving up the market. BlackRock, for instance, recently launched a suite of “evolved” sector ETFs that use machine-learning techniques to analyze company filings and group stocks according to “where the firms see their own growth,” says Prince. These are actively managed ETFs without a benchmark index, essentially run by machines. Stocks defying categorization wind up in different funds: iShares Evolved US Technology (IETC) has an 8% weighting in Amazon, while iShares Evolved US Discretionary Spending (IEDI) has 12% of its assets in the stock.
Companies like Amazon “are very dynamic and do things in different industries, yet we traditionally classify them in one area,” says Prince. “It’s about where the company’s head is, and identifying future trends.”
Nonetheless, for many money managers and investors, the new sector lineup will have broad implication as stocks migrate and sectors become more concentrated in certain industries or companies.
One of the biggest impacts will be on tech—a sector that has grown so big, at 26.5% of the S&P 500, it has produced more than half of the market’s gain this year, according to Bespoke Investment Group. Tech is being cut down to size, though, as several of its biggest stocks head over to the new communication sector. Alphabet and Facebook are leaving, along with Activision Blizzard (ATVI), Electronic Arts (EA), Twitter (TWTR), and Take-Two Interactive Software (TTWO).
The losses will chop about 23% off the tech sector’s market value. It will be more oriented to chip makers, hardware, and software, including Apple, Microsoft (MSFT), and Intel (INTC).
It also looks more like old tech from the 1990s and early 2000s, dominated by hardware, software, and semiconductor companies. These are capital-intensive, cyclical businesses with less “secular” growth than the internet and social-media companies departing for communication services, says Scott Opsal, director of research for Leuthold Group. Tech will look more industrial. The companies are growing nicely, as the industry builds out data-server farms and other digital infrastructure. But many of them don’t have the pure, steady growth associated with social-media, mobile, and cloud-computing services, now at home in communication services.
Apple will be even more of a dominant presence in tech at 20.2% of the total, up from 15.6%. But it’s an outlier of sorts. It looks more like a consumer-discretionary stock: Cellphones are increasingly disposable items with upgrade cycles every few years. The business model is nothing like that of hardware makers or other firms that sell capital equipment and tech services to businesses.
However you slice it, tech’s growth profile will shrink. The sector’s price/earnings ratio will drop a point, to 17.7, and 2018 earnings growth will fall from 20% to 17.2%, according to Credit Suisse. However, the sector’s free-cash-flow yield will jump from 4.4% to 4.9%, and return on equity will increase from 28.5% to 31.4%. Those are signs of a slower-growth sector whose constituents are converting more invested capital to profits.
Communication should pick up where tech leaves off, and it does in some ways. About half of the sector comes from tech. The remainder consists of media and telecom companies, including CBS (CBS), Comcast (CMCSA), Netflix (NFLX), AT&T (T), and Verizon Communications (VZ).
Yet the notion that Alphabet and Facebook belong in the same bucket as AT&T, Comcast, and Verizon strikes some analysts as peculiar, at best. Sure, Comcast and AT&T both own Hollywood studios (Universal and Time Warner), while Verizon owns Yahoo! But the telecom and cable business models still rely on charging rents for pipes. They’re also heavily indebted, capital-intensive businesses that look nothing like the asset-light internet darlings. “Internet companies are sexy, exciting high growth firms that don’t pay dividends,” says Opsal. “The telecoms are almost the exact opposites.”
Historically, the telecoms would have been a drag on the sector’s returns. Opsal rebuilt the Communication sector as if it had existed since the day Google joined the S&P 500 on March 31, 2006: The now-included internet industry returned an average 14.4% a year. Media came in second place at 11.9%, and telecom brought up the rear at 6%, including dividends. Shares of AT&T and Verizon have bounced 5% over the past month, as ETFs added the stocks. But they’re likely to weigh on the sector’s performance.
As for discretionary, it will be more at Amazon’s mercy. The sector is losing its media wing, including Walt Disney (DIS), Netflix, Comcast and 21st Century Fox (FOXA), all heading to communication. The sector is gaining eBay (EBAY) and a few other stocks. But it will be more of a play on retail, dominated by Amazon, which will jump to 35% of the sector, up from 27.7%.
Investors may not mind that Amazon will be a bigger slice of the pie. Discretionary has been one of the top performers over the past five years, almost entirely due to Amazon’s heavy weighting, notes Opsal. But that worries some analysts. “Everybody loves Amazon, and Amazon is doing great,” says Pat Tschosik, U.S. sector strategist for Ned Davis Research Group. “But what if Amazon falls from greatness?”
Whether Amazon belongs in a basket with McDonald’s (MCD), Ford Motor (F), and Kohl’s (KSS) is another debate. Sure, you can make a case that Amazon is technically a retailer. But its business model isn’t anything like that of a department store or car manufacturer. Amazon’s profits increasingly come from its thriving cloud business, Amazon Web Services. AWS hauled in $4.3 billion in 2017, well above the $2.8 billion that Amazon reported for its North American business, home to online retail sales and products like the Kindle.
One move that isn’t controversial is putting the telecom sector out of its misery. The sector has dwindled to three stocks, accounting for 2% of the S&P 500. The sector had become an afterthought for many active managers. And the telecom ETFs that populate the market all hold other stocks, such as communications-equipment companies, to meet regulatory requirements for a diversified portfolio.
Communication, however, is no substitute. It will be much more cyclical than telecom, have above-average volatility, and yield an estimated 1.3%, compared with 5% for the telecom sector. “They’ve taken one of the more stable and resilient bear-market sectors—telecom—and turned it into one of the higher-risk sectors,” says Jim Stack, head of Stack Financial Management, a registered investment advisor.
Investors may need to adjust their portfolios after the reshuffling. Some funds will change names or swap holdings. Complicating matters: S&P and MSCI are on different timetables. S&P plans to institute its GICS reclassifications in September while MSCI is aiming for early December, putting some ETFs in limbo for a few months.
The biggest changes will occur in funds that closely track S&P 500 sectors, such as the $143 billion parked in State Street’s SPDR ETFs. State Street launched the Communication Services Select Sector SPDR ETF (XLC) in June. The firm plans to rebalance its Consumer Discretionary Select Sector SPDR (XLY) and Technology Select Sector SPDR (XLK) after the market closes on Sept. 21.
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BARRON'S COVER A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
ByDaren Fonda Updated Aug. 31, 2018 9:36 p.m. ET
A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
PHOTO: JAVIER JAÉN
Think of Big Tech and companies like Alphabet, Amazon, Apple, and Facebook come to mind. The firms dominate our digital lives, living on our cellphones and influencing how we interact with people, buy things, get to places, access information, and consume entertainment. Their market impact has also been huge: These four stocks have returned 33.7% annually over the past five years, on average, versus the S&P 500’s 14.5%.
Yet while many investors want Big Tech in a basket, David Blitzer wants to cut the group down to a more manageable size. “Based on what these companies do and who they compete with, it makes sense to categorize them differently,” says Blitzer, chairman of the index committee at S&P Dow Jones Indices. “The world ain’t what it used to be.”
A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
PHOTO: JAVIER JAÉN
Sector investing won’t be the same, either, after the unprecedented overhaul by S&P and MSCI of their Global Industry Classification System, or GICS, a widely used taxonomy that carves up the stock market into sectors, industry groups, industries, and subindustries. The biggest change: A new sector, communication services, is rising from the ashes of the telecommunication-services sector, which will go extinct. The communication sector will cherry-pick stocks from the tech, consumer-discretionary, and telecom bins. And it will be a biggie, the fourth-largest (tied with consumer discretionary) out of 11, behind information technology, health care, and financials. S&P plans to reconstitute its indexes after the market closes on Sept. 28. MSCI’s changes will go into effect on Dec. 3.
For investors in broad index funds, this may seem like much ado about nothing. But a great migration of hundreds of stocks has broad market implications. Some sectors will become more heavily concentrated in a few big names—notably, Apple (ticker: AAPL) in technology, Amazon.com (AMZN) in consumer discretionary, and Facebook (FB) and Alphabet (GOOGL) in communication services. “This will be a meaningful change, and not just because of the migration of stocks. It’s also what happens afterward, and how market cap will be distributed,” says Daniel Prince, head of iShares product consulting at BlackRock.
Your Portfolio Might Change Following This Sector Shuffle
Alphabet and Facebook will no longer be part of the tech sector once S&P and MSCI change the way they classify companies.
The changes will have a ripple effect throughout virtually all professional money management, and could mean big changes for investors’ portfolios. Strategists and advisors constantly make sector recommendations, advising clients to rotate through sectors as industry dynamics change. Many quantitative hedge fund managers use sector exchange-traded funds to hedge stock positions. Active managers use sectors as guidelines or benchmarks in their portfolios. Reports breaking down a fund’s performance show whether a manager’s skill at picking stocks is driving the returns, or whether it’s a result of sector weightings. Many funds also aim to outperform by rotating between sectors, going “overweight” or “underweight” at different times.
For individual investors, sectors can be a good way to make tactical shifts, too. Industrials, energy, materials, consumer discretionary, and technology tend to outperform when the economy is winding up. Consumer staples, health care, telecom, and utilities fare best in a downturn. Sectors are also home to bubbles: tech in the late 1990s and financials in the mid-2000s. Avoiding overheated sectors can help you sidestep market excesses.
READ THE SIDEBAR
Tech Stocks Could Be Winners in Big Sector Shift
Of course, sector funds that follow the GICS framework aren’t the only way to go. Investors can assemble their own customized baskets of stocks at minimal cost; trading commissions are down to zero at discount brokerages such as Merrill Edge. Traditional sector ETFs offered by BlackRock, Fidelity, State Street, and Vanguard account for more than $260 billion in assets. That leaves another almost $210 billion in sector ETFs that slice the market in all kinds of other ways.
Sector investing is rapidly evolving, as ETF sponsors apply new techniques to carving up the market. BlackRock, for instance, recently launched a suite of “evolved” sector ETFs that use machine-learning techniques to analyze company filings and group stocks according to “where the firms see their own growth,” says Prince. These are actively managed ETFs without a benchmark index, essentially run by machines. Stocks defying categorization wind up in different funds: iShares Evolved US Technology (IETC) has an 8% weighting in Amazon, while iShares Evolved US Discretionary Spending (IEDI) has 12% of its assets in the stock.
Companies like Amazon “are very dynamic and do things in different industries, yet we traditionally classify them in one area,” says Prince. “It’s about where the company’s head is, and identifying future trends.”
A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
Nonetheless, for many money managers and investors, the new sector lineup will have broad implication as stocks migrate and sectors become more concentrated in certain industries or companies.
One of the biggest impacts will be on tech—a sector that has grown so big, at 26.5% of the S&P 500, it has produced more than half of the market’s gain this year, according to Bespoke Investment Group. Tech is being cut down to size, though, as several of its biggest stocks head over to the new communication sector. Alphabet and Facebook are leaving, along with Activision Blizzard (ATVI), Electronic Arts (EA), Twitter (TWTR), and Take-Two Interactive Software (TTWO).
The losses will chop about 23% off the tech sector’s market value. It will be more oriented to chip makers, hardware, and software, including Apple, Microsoft (MSFT), and Intel (INTC).
It also looks more like old tech from the 1990s and early 2000s, dominated by hardware, software, and semiconductor companies. These are capital-intensive, cyclical businesses with less “secular” growth than the internet and social-media companies departing for communication services, says Scott Opsal, director of research for Leuthold Group. Tech will look more industrial. The companies are growing nicely, as the industry builds out data-server farms and other digital infrastructure. But many of them don’t have the pure, steady growth associated with social-media, mobile, and cloud-computing services, now at home in communication services.
A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
Apple will be even more of a dominant presence in tech at 20.2% of the total, up from 15.6%. But it’s an outlier of sorts. It looks more like a consumer-discretionary stock: Cellphones are increasingly disposable items with upgrade cycles every few years. The business model is nothing like that of hardware makers or other firms that sell capital equipment and tech services to businesses.
However you slice it, tech’s growth profile will shrink. The sector’s price/earnings ratio will drop a point, to 17.7, and 2018 earnings growth will fall from 20% to 17.2%, according to Credit Suisse. However, the sector’s free-cash-flow yield will jump from 4.4% to 4.9%, and return on equity will increase from 28.5% to 31.4%. Those are signs of a slower-growth sector whose constituents are converting more invested capital to profits.
Communication should pick up where tech leaves off, and it does in some ways. About half of the sector comes from tech. The remainder consists of media and telecom companies, including CBS (CBS), Comcast (CMCSA), Netflix (NFLX), AT&T (T), and Verizon Communications (VZ).
Yet the notion that Alphabet and Facebook belong in the same bucket as AT&T, Comcast, and Verizon strikes some analysts as peculiar, at best. Sure, Comcast and AT&T both own Hollywood studios (Universal and Time Warner), while Verizon owns Yahoo! But the telecom and cable business models still rely on charging rents for pipes. They’re also heavily indebted, capital-intensive businesses that look nothing like the asset-light internet darlings. “Internet companies are sexy, exciting high growth firms that don’t pay dividends,” says Opsal. “The telecoms are almost the exact opposites.”
Historically, the telecoms would have been a drag on the sector’s returns. Opsal rebuilt the Communication sector as if it had existed since the day Google joined the S&P 500 on March 31, 2006: The now-included internet industry returned an average 14.4% a year. Media came in second place at 11.9%, and telecom brought up the rear at 6%, including dividends. Shares of AT&T and Verizon have bounced 5% over the past month, as ETFs added the stocks. But they’re likely to weigh on the sector’s performance.
A Market Shakeup Is Pushing Alphabet and Facebook Out of the Tech Sector
As for discretionary, it will be more at Amazon’s mercy. The sector is losing its media wing, including Walt Disney (DIS), Netflix, Comcast and 21st Century Fox (FOXA), all heading to communication. The sector is gaining eBay (EBAY) and a few other stocks. But it will be more of a play on retail, dominated by Amazon, which will jump to 35% of the sector, up from 27.7%.
Investors may not mind that Amazon will be a bigger slice of the pie. Discretionary has been one of the top performers over the past five years, almost entirely due to Amazon’s heavy weighting, notes Opsal. But that worries some analysts. “Everybody loves Amazon, and Amazon is doing great,” says Pat Tschosik, U.S. sector strategist for Ned Davis Research Group. “But what if Amazon falls from greatness?”
Whether Amazon belongs in a basket with McDonald’s (MCD), Ford Motor (F), and Kohl’s (KSS) is another debate. Sure, you can make a case that Amazon is technically a retailer. But its business model isn’t anything like that of a department store or car manufacturer. Amazon’s profits increasingly come from its thriving cloud business, Amazon Web Services. AWS hauled in $4.3 billion in 2017, well above the $2.8 billion that Amazon reported for its North American business, home to online retail sales and products like the Kindle.
One move that isn’t controversial is putting the telecom sector out of its misery. The sector has dwindled to three stocks, accounting for 2% of the S&P 500. The sector had become an afterthought for many active managers. And the telecom ETFs that populate the market all hold other stocks, such as communications-equipment companies, to meet regulatory requirements for a diversified portfolio.
Communication, however, is no substitute. It will be much more cyclical than telecom, have above-average volatility, and yield an estimated 1.3%, compared with 5% for the telecom sector. “They’ve taken one of the more stable and resilient bear-market sectors—telecom—and turned it into one of the higher-risk sectors,” says Jim Stack, head of Stack Financial Management, a registered investment advisor.
The Great Reshuffling
Current Sectors by Market Cap
Square size is proportional
to market cap.
Unaffected stock
Affected stock
Consumer Discretionary
$3.5 trillion
Information Technology
$6.9 trillion market cap
IBM
2.0%
Amazon
27.7%
Booking
Holdings
2.6%
Cisco
3.2%
Apple
15.6%
Intel
3.3%
Alphabet
12.7%
Home
Depot
6.6%
Other
29.7%
McDonald’s
3.6%
Microsoft
12.5%
Charter
Communications
2.3%
Starbucks
2.0%
Nike
3.8%
Other
28.5%
Lowe’s 2.5%
Facebook
7.4%
Netflix
4.6%
Walt Disney
4.8%
Comcast
4.8%
Mastercard 3.2%
Other 3.1%
Nvidia 2.5%
$484 billion
Telecommunication
21st
Century
Fox
2.4%
Visa 4.3%
Other 2.0%
Oracle 2.8%
Verizon 46.6%
AT&T 48.4%
CenturyLink
5.0%
Sectors After Reclassification by Market Cap
Information Technology
$5.3 trillion market cap
Consumer Discretionary
$2.8 trillion
IBM
2.5%
Amazon
35.0%
Booking
Holdings
3.3%
Cisco
4.2%
Apple
20.2%
Intel
4.2%
The new
Information
Technology
sector will be
largely
dominated
by hardware,
software and
semiconductor
companies.
Home
Depot
8.3%
Other
38.4%
McDonald’s
4.5%
Microsoft
16.1%
Nike
4.8%
Other
36.1%
Lowe’s 3.2%
Starbucks
2.6%
Mastercard 4.2%
The Telecommunication
sector is fully absorbed
into the new Communication
Services sector.
NVIDIA 3.2%
Visa 5.6%
Oracle 3.7%
Charter
Communications
2.9%
NEW: Communication Services
$2.8 trillion
Walt
Disney
6.0%
Netflix
5.8%
21st Century Fox
3.0%
Comcast
6.1%
Facebook
18.3%
Alphabet
31.5%
Other 3.9%
AT&T 8.4%
Verizon 8.1%
CenturyLink
0.9%
Other
5.0%
Note: Market cap as of Aug. 29, 2018
Source: Bloomberg; S&P Dow Jones Indices; Barron’s calculations
Investors may need to adjust their portfolios after the reshuffling. Some funds will change names or swap holdings. Complicating matters: S&P and MSCI are on different timetables. S&P plans to institute its GICS reclassifications in September while MSCI is aiming for early December, putting some ETFs in limbo for a few months.
The biggest changes will occur in funds that closely track S&P 500 sectors, such as the $143 billion parked in State Street’s SPDR ETFs. State Street launched the Communication Services Select Sector SPDR ETF (XLC) in June. The firm plans to rebalance its Consumer Discretionary Select Sector SPDR (XLY) and Technology Select Sector SPDR (XLK) after the market closes on Sept. 21.
‘At 27% of the S&P 500, the tech sector has produced more than half of the market’s gain this year.’
Vanguard is going slow, as usual, as it transitions three of its sector funds and ETFs to the new lineups. The Vanguard Information Technology ETF (VGT) has shed almost all of its holdings in Alphabet, Facebook, Activision Blizzard, and Electronic Arts, all now in the Vanguard Communication Services fund (VOX), formerly a telecom ETF. Verizon and AT&T, half of the old telecom ETF’s assets, have been whittled to 20% of the portfolio at the end of July, notes Jeffrey DeMaso, director of research for the Independent Adviser for Vanguard Investors newsletter.
Most of BlackRock’s iShares sector ETFs, covering more than $50 billion in assets, follow indexes licensed by Dow Jones and Nasdaq. They aren’t directly affected by the GICS changes. Nonetheless, the iShares Global Tech ETF (IXN) will lose Facebook, Alphabet, and Tencent Holdings (700.Hong Kong). They’ll be moving to iShares Global Telecom (IXP), which will have a new name, iShares Global Communication Services.
Fidelity plans to reposition its ETFs, too: Fidelity MSCI Telecommunication Services Index (FCOM) will become a communication services ETF in late November. Fidelity MSCI Information Technology Index (FTEC) will make the switch to the new GICS framework, losing its internet and gaming stocks to the communication sector.
Thankfully, S&P and MSCI don’t make such changes often. The GICS taxonomy goes back to 1999. It has grown to 11 sectors, the latest being real estate, carved out of financials in 2016. But that was minor compared with the new musical chairs—affecting more than 1,100 companies globally.
Redrawing the GICS boundaries was necessary to reflect the changing tech and media landscapes. When the old sector lines were drawn, people made calls with flip phones, used MySpace for social media, and paid AT&T for cellular service and landlines. But mergers and tech developments have jumbled things up: Netflix is threatening Hollywood, Comcast has turned into a media giant, and Alphabet is in everyone’s business.
Sure, technology remains the heart of these businesses. But so what? Facebook and Alphabet aren’t like Apple and Microsoft, which develop hardware and software, says Blitzer. It makes more sense to group Facebook and Alphabet with firms making money off advertising, content delivery, and other types of “communications,” he says.
Blitzer defends the inclusion of telecom in communications. Lumping the stocks with utilities didn’t make sense because utilities are so heavily regulated. Market forces, more than regulators, prevent the telecoms from charging higher prices. And they’re facing off against everyone from Alphabet to Disney. “These aren’t your grandfather’s telecom companies,” he says.
If nothing else, telecom and media stocks are keeping the sector’s volatility in check, at just above the S&P 500’s level. Moreover, the sector will morph: Tech developments or mergers may favor internet firms, or lift the media and telecom companies. Investors won’t have to choose, getting both in one basket.
Regardless of their constituents, the tech and communication sectors still offer some of the highest growth in the market, at reasonable valuations. Tech stocks look cheap, says Denise Chisholm, sector strategist with Fidelity Investments. With or without the internet stocks, the sector currently trades in the bottom quartile of its valuation range since 1962, she says, and it’s in the top quartile for operating margins. “You’re paying some of lowest-level valuations for some of the best business operational capacity and margins,” she says. The trajectory of margin expansion looks positive, she adds, and it’s what drives returns.
The communication sector looks reasonably priced, too, says Opsal. It trades at a price/earnings ratio of 21, slightly above the market average. That isn’t steep for a sector dominated by high-quality secular growth companies that aren’t capital intensive. “You’re paying a modest premium for superior business models and cash flow generators,” he says.
Investors should still be wary of tech overload. Splintering the sector renders it a smaller component of the S&P 500. But it doesn’t reduce tech exposure for investors who see their telecom ETF morph into a communication fund, resulting in tech overlap. S&P may classify the stocks differently. But if tech falls out of favor, the impact will be felt across the board.
Of course, S&P and MSCI don’t have a lock on sector investing. Many ETFs focus on tech subindustries such as semiconductors, or use “smart beta” techniques that rank stocks by valuation, growth, or other metrics associated with outperformance. BlackRock’s iShares is pushing the envelope with its “evolved” ETFs, covering tech and six other industries, including funds such as iShares Evolved US Innovative Healthcare (IEIH) and iShares Evolved US Media & Entertainment (IEME). Technically, these are sector ETFs, but they don’t look anything like GICS-based sector funds. Stocks overlap in different sectors, reflecting their multifaceted businesses, and BlackRock says that sector constituents will change more frequently than traditional classifications to capture evolving business trends. Similarly, iShares Exponential Technologies (XT) crosses sector boundaries to find innovative companies involved in Big Data and robotics; a third of the fund is in tech, another third in health care, and the rest in other sectors.
Yet changing the ingredients may not be a recipe for superior returns. The XT ETF has fared well this year, up 11.2%, edging the S&P 500. Its three-year 18.3% annualized return beat the market’s 15.8% annualized gain, but other ETFs that slice up sectors in different ways aren’t so successful. Indeed, BlackRock closed 16 multifactor ETFs in June, including its iShares Edge MSCI Multifactor Technology ETF, which had been trailing the S&P 500 tech sector.
Investors who want broad tech exposure still have options. The iShares North American Tech ETF (IGM), home of Facebook and Alphabet, will keep these stocks. The fund includes Amazon, Netflix, and other stocks that won’t be in the S&P 500 tech sector. The downside: The ETF is pricey, with an expense ratio of 0.47%.
In telecom, investors won’t have many choices as State Street, Fidelity, and Vanguard switch to communication sector ETFs. The iShares U.S. Telecommunications ETF (IYZ) will be the last broad U.S. telecom ETF standing, holding a third of its assets in telecom services and more than half in communication-equipment makers like Cisco Systems (CSCO) and Motorola Solutions (MSI). It yields 2.8% and has about half of the S&P 500’s volatility. The fund’s expense ratio is a steep 0.43%.
Ultimately, the GICS changes won’t affect one of the oldest, largest, and most liquid tech-heavy ETFs, Invesco QQQ Trust (QQQ). Tracking the largest 100 nonfinancial stocks on the Nasdaq exchange, the $72 billion fund holds all of Big Tech, regardless of sector classification. It also holds 15% in defensive consumer and health-care stocks, which may not be a bad thing if tech eventually stumbles.